Volatile oil prices here to stay, as demand outpaces production

Economies need cuts in capacity, experts say


WASHINGTON - When a tropical depression in the Caribbean was upgraded to Tropical Storm Dennis this week, crude oil prices immediately began climbing on the New York Mercantile Exchange.

Traders feared that at least one of the four tropical depressions off the U.S. Atlantic and Gulf coasts could become a hurricane that would delay oil deliveries, damage offshore oil rigs and threaten onshore refineries. That means temporary oil shortages are possible, a fear that drives up fuel prices.

Volatile oil prices look as if they're here to stay, experts agree, at least for a year or two. Why? Partly because world oil demand is growing faster than oil production. Partly because financial speculators are gaming the markets. And partly because nobody knows just how much oil is available, not least because it's unclear just how much oil Saudi Arabia has.

It is clear the growing appetite for oil in China, India and other emerging economies has reduced the world's margin of extra oil-production capacity. The world consumes about 84 million barrels of oil per day. If every well in the world is producing flat out, analysts said, total production could equal no more than 86 million barrels a day. That small margin of extra capacity isn't much of a cushion against unforeseen events such as a terrorist attack, refinery fire, pipeline rupture or natural disaster such as last September's Hurricane Ivan, which damaged oil rigs and platforms and removed about a half-million barrels a day from the U.S. market for months.

That's why markets are nervous and fuel prices are high. U.S. oil inventories are near all-time highs, so there's no supply shortage here. But if anything cuts oil production anywhere in the world, there could be a shortage very soon.

"Clearly, we are in a situation where the likelihood of us entering a supply-tightness scenario has increased, and that's what this market is playing off - that fear of what could happen," said Kyle Cooper, an oil analyst with Citigroup Inc. in Houston. "Fear and psychology are major market factors."

Crude oil prices closed at $61.28 a barrel yesterday, the highest price since oil began trading in 1983 on the New York Mercantile Exchange. But when adjusted for inflation, today's prices remain well below those of the 1980 oil crisis, when oil reached more than $90 a barrel in today's dollars.

So, expect volatile prices, partly because speculators are gaming the market. With surging demand for oil and additional production years from reaching market, conditions are rife for financial speculation.

The price of oil is set in markets, where traders buy contracts, called "futures," for deliveries of oil at a future date. Some of today's heavy trading in futures reflects industrial users buying oil now at a set price to protect themselves in case prices have risen even higher when they need the oil.

Other oil futures contracts are being bought by speculators such as hedge funds that have no intention of taking delivery of the oil. They bid up the price of futures contracts, then sell them to take profits. This explains some of today's volatility. How much of today's futures buying stems from speculation is impossible to quantify, but experts said it was having a significant impact on prices.

"Current oil prices are basically where they are because about half of the people following oil are sure the prices are going to collapse. And the other half are actually trying to make sure they have enough oil to get through the summer," said Matthew Simmons, who runs a Houston investment bank specializing in the oil industry. "If you had 9 out of 10 people who thought we're going to have a problem, oil prices would be way higher than they are today."

Simmons is one who thinks we're going to have a problem. His new book, Twilight in the Desert, asserts that oil production in Saudi Arabia has reached or is near peak production.

If that's true, the remaining oil there would be harder and costlier to pump out. Once that point comes, Saudi Arabia - home to an estimated one-quarter of the world's oil reserves - would begin a downward slide in annual production that could drag down the global economy.

To calm fears provoked by Simmons' book, Khalid al Falih, a senior vice president for the Saudi state oil company Aramco, came to Washington on June 27 to assure that all is well in the Saudi oil industry.

"We have in these reserves over 100 years at current production," al Falih told a standing-room-only audience at the Center for Strategic and International Studies, a conservative research center.

That sounds great if you take the Saudi government at its word. Little independent auditing of oil reserves is done, and few experts think that existing production and delivery numbers are accurate.

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